Most of the discussions about the need for greater transparency in financial transactions have centered on the need to adopt greater fiduciary responsibilities.
But there is also another reason: economic.
Or, more specifically, mutual funds benefit financially from the lack of transparency.
When fund companies make it difficult for investors to choose between the 8,029 mutual funds and 21,631 different share classes*, the fund companies stand to profit from this paralyzing confusion. Most investors are simply overwhelmed from the data, so they fall victim to sharp salesmanship.
That’s why fund companies intentionally make the process more complicated, according to MIT Professor Gustavo Manso and fellow researcher Bruce Ian Carlin, who said “financial services firms over-complicate their products to maximize profits; the more they confuse investors, the more money they make.”
Professor Manso and Carlin of UCLA’s Anderson School of Management, said in their paper, Obfuscation, Learning, and the Evolution of Investor Sophistication, that there is a distinct financial motive behind the lack of transparency.
Fund companies encourage the lack of transparency by creating new types of fees, share classes or changing managers. These unanticipated fund changes make it more difficult for the average investor to understand what is actually happening at the fund.
As a result, unsophisticated investors end up buying more expensive funds, while more sophisticated investors buy lower-cost alternatives. The marketing is designed to obfuscate, not educate, the authors contend.
The paper address the costs of obfuscation to sophisticated, unsophisticated and fund companies, the optimal time to obfuscate, the extra rents available from unsophisticated investors, the baseline financial education that investors possess, the speed at which learning takes place, and the underlying mechanism in which sophistication evolves.
The study also supports other research which found that education may not be an effective solution in retail financial markets.
What makes the paper of interest to people advocating the adoption of a fiduciary standard is that it that it confronts the lack of transparency as a profit motive, not a legal one.
Certain people and companies benefit monetarily when people are confused. When the financial markets are inherently complex, the additional complexity from thousands of share classes, ETFs, and look-alike mutual funds paralyzes investors or encourages them to make costly, incorrect decisions.
At the least, the paper shows that confusion is a very profitable business for too many mutual fund companies.
How Investors Can Combat the Confusion
While fund companies may be intentionally trying to make a complicated situation more complex, investors can avoid the noise by doing the following:
–Decide on an investment strategy before you choose funds. Since there are too many funds to choose from and many of them are not significantly different from one another, investors have to examine the funds which fit into their strategy. This will narrow down the choices. A critical examination of the cost and performance data, manager stability and ownership, and fund company reputation should focus the research. Avoid the bling and advertising hype, especially about the funds star-rankings over the past few quarters. Short-term rankings do not prove anything.
–Avoid owning too many funds. Undisciplined investors tend to own too many funds. A portfolio is a collection of individual funds, not a seemingly random assortment. Do not chase performance. For example, precious metals funds do not belong in all portfolios, regardless of the advertising claims. If anything, the portfolio can borrow key concepts from military strategy which seeks to maximize the main effort, while holding assets in reserve. Scattering assets detracts from the main strategy. Using a core-satellite strategy, a model portfolio would have an equity and bond core positions, and 2-3 satellites for each core fund.
–It’s OK to own boring funds. Many people fail to note the difference between trading and investing, which are dramatically different processes for very different types of people. Know which one you are; that will be a great place to start the simplification process.
*As of 2007. Source: Investment Company Institute